Insolvent Periods of High Sales Growth - Assignment Example

Question Many business fail through poor cash flow, even whilst their published accounts show a profit on trading activities. Explain why this might be the case and explain what managers can do to avoid becoming insolvent through periods of high sales growth. Answer It is an established truth that many businesses fail through poor management of cash flow despite the fact that their published accounts show a profit on their trading activities. This is mainly due to the fact that they do not keep a close check on their cash flow and that the cash outflow from the business is more than the cash inflow into the business. Increased cash outflow over the cash inflow is mainly due to many reasons which require a close look into the affairs of the business. Most of the businesses come to know about the poor cash flow problem at the time when this situation really gets worse and the business has no money to pay for its debts and credits. However, if managed properly many businesses can survive through the same revenue and profit. This case may arise due to the fact that the business has some or all of the factors described below. Too many debtors. Too many creditors. Over financing. Over trading. Over Investment. Taking short term loans from banks for operating activities. Poor Cash Budgeting This may happen due to the fact that companies have either too many debtors who do not pay or too many creditors whom business has to pay constantly after some fixed time. Business has made over financing or over trading resulting in the cash of business being stuck for some time. It is a good move from the side of businesses to reinvest the money they have into the business but this too results in the decrease in cash in hand in some cases. One of the most crucial aspects of cash management is cash budgeting and it has been observed that many businesses especially the small ones fail to make cash budgets which eventually results in the over cash outflows from the business. Managers Actions During the period of high sales growth there is a fear of tightened cash situation for the business. This is due to the fact that business has to pay for the purchases made on time in order to avoid any amount of interest on the late payment and at the same time they rely heavily on the timely payment from their debtors which is most of the times not appropriately honored. Thus, the cash of the business is stuck for some time resulting in the halt of operational activities. In order to avoid the above described situation, managers need to come up with a sound plan for appropriate cash management. This can be done through making comprehensive cash budgets in which the target for cash inflow and cash outflow is set. For this purpose, there is a need to identify, analyze and determining cash needs of the business and prioritizing those needs. Properly assessing the current and future cash needs of the business and having an appropriate plan to meet all cash requirements of the business. Businesses should try to accumulate cash for the business through the working activities rather than converting assets into cash when there is a need for cash in the business. Managers should manage very effectively all of the financial commitments of the business and avoid bad debt or excessive credit at any cost. Managers should make sure that they avoid any sort of illiquidity or low liquidity levels because this situation can put the business activities into the halt. Reinvesting the excess cash again into the business can ensure that cash requirements of the business are met. For the purpose of saving the business from uncertain events and situations, it is advised to make a cover for such risks through insurance policy acquisition or something like it. Thus, risk management is also extremely beneficial in saving the cash of the business. If cash is managed properly then there is every reason for the business to prosper and if managed badly there is a risk of losing control over cash and eventually the business. Question 2 You have been asked to analyze the financial position of three companies that operate in the food retail industry. The ratios for the last financial year were: company A B C Gross profit margin % 15 22 40 Net profit margin % 9 10 12 Return on capital employed % 15 13 16 Return on shareholders’ funds % 20 13 12 Stock days 18 25 45 Debtor days 9 32 65 Creditor days 9 42 55 Earnings per share 15p 20p 25p Price earnings ratio 16 12 19 Dividend Yield % 7 8 4 Required: a) Comment on the companies’ profitability b) Comment on the companies’ working capital management c) Comment on the investment ratios. IF you were going to buy one of these companies’ shares, which one would you choose? Explain your reasons. Answer Companies’ Profitability The gross profit margin percentage shows 15% for company A, 22% for company B and 40% for company C. This shows us that the gross profit on sales highest for company C with the percentage of 40%. Thus, company C is earning highest level of gross profit on sales of its products in the market following company B with gross profit margin percentage of 22% and then at last company A with 15% of gross profit margin. This is mainly due to the fact that company C manages to secure cheaper purchases from the market. This may be mainly due to the fact that company C purchases raw materials in bulk quantities. The net profit margin percentage of each company is shown as 9%, 10% and 12% for company A, B, and C respectively. There is seen a sharp decrease in net profit margin of company C as compared to the gross profit margin. The sharp decline from 40% to 12% shows that the company is bearing heavy non manufacturing and non trading expenses like administrative expenses or this may be due to heavy financial costs. This may be due to the big size of the company as big companies have big administrative infrastructures and thus the infrastructures cost higher. However, the company is not able to realize its gross profit margin might till the end and thus making very humble profits. Same is the case with company B which also sees a decline, although less as compared to C, from its healthy gross profit margin of 22% to 10% net profit margin. Company A shows a healthy rate and less diversion as compared to other countries and has made healthy profits at the end keeping in view the gross profit margin percentage of the company. This may be mainly due to the small size of the company that company A is saving on administrative and financial costs. Working Capital Management Return on capital employed ratio presents a general overview about the working capital management of the company. Working capital is the relation of short term assets and short term liabilities of the company. It is the capital that is employed for the day to day trading and other expenses of the company. According to the ratios shown by the companies, company C successfully manages working capital at 16% return which is also the highest of all three companies. Company A also manages to maintain good controls over the working capital needs of the company and manages to get 15% return on capital employed. Company B shows a slightly lower return of 13% on capital employed as compared to the rate prevailing in the industry. It is worthy to state here that as much little amount of working capital will be used for operational purposes the return on capital employed will be that much higher. Return on capital employed tells us how much profit is earned from the investment of shareholders in the company. As the figures show, company C is offering highest level of return on capital employed and thus it can be said that company C has been able to utilize the investment of shareholders in the most useful manner. Return on share holder’s funds depicts the actual amount of profit that is to be earned by the investors after investing in any company. Hence, return on shareholder’s funds is the measure of profitability in the company as it assists the investors in knowing that the company is profitable and that any investments made in the company will yield how much profit to them. Return on shareholder’s funds is shown in the percentage of tax after profits and preference dividends. In the figures shown by the three companies, company A has been able to show more commitment to the investors for return on their investments. Company A has managed to get return on shareholder’s funds at 20% compared to those of 13% and 12% of those of companies B and C respectively. Rate of 20% is a very high rate of return in lieu of return on shareholder’s funds. Thus it is better to invest in company A as compared to other companies. Through the analysis of all of three companies, it is evident that the working capital management of company A is far better than the working capital management of other companies. Investment Ratios Earnings per share show the promising figures of 15p, 20p and 25p for company A, B and C respectively. This tells us that the earnings with regard to a single share of the company C are highest as compared to other companies of the same food industry. Company C manages to offer to highest return on each and every share bought in the company and thus offers a promising investment for the investors in the company. Price earnings ratio illustrate that all of the three companies have earned how much profit with regard to their shares’ prices in the stock market. This ratio throws light on the strength of company’s shares and how much money can be earned by the company with respect to the prices of its shares in the stock market. Price earnings ratio is calculated on the price of shares in market with relation to earnings per share of the company. Price earnings ratio calculation of three companies demonstrate that company A has managed to get 16% in lieu of price earnings ratio whereas company B has earned 12% in lieu of price earnings ratio and company C has maintained the price earnings ratio at 19% of the shares of prices in the market. This trend shows to the investors and company C has better offering for their investment as compared to the other two companies. Dividend yield ratio gives an idea about the dividends paid by the company as compared to the market price of the shares. It is with the help of this ratio that the investor identifies that how much return he or she is going to get from the company in terms of percentage of the market of company’s shares. Figures calculated for this purpose demonstrate us that company A has managed to earn dividend yield of 7% and company B has earned dividend yield of 8% on its shares, whereas, on the contrary company C has earned the dividend yield of only 4% on its shares. Thus, company C is showing fewer yields on its shares in terms of its dividend as compared to the other two companies. Investment Decision If I had to buy the shares of any of these companies, I would have bought the shares of company C. This is because company C offers a high return on the investments made in the company as compared to other two companies in the same industry. Earnings per share ratio and price earnings ratio of company C gives an idea of the profitability of the company and both of these ratios show a promising return on the investments made in the company. Although company C is showing a lesser dividend yield ratio but this is not of extreme significance in this decision as this might be the case that company C’s shares are traded at higher rate in the market due to its large size or its good worth in the market. However, if I am shot of money and cannot purchase company C’s shares then I will go for the purchase of company A’s shares which is the most lucrative company to invest in after company C. References Harold Randall. (1994). Accounting. Pearson Education Wachowicz and Horne. (2004). Fundamentals of Financial Management. Prentice Frank Wood.(2000). Accounting For Managers. Prentice Bized. (2010). A comprehensive online resources. Retrieved on 4 May 2010. www.bized.edu Eugene Brigham. (2003). Financial Management. Southwestern Publishing Investopedia. (2010). Online Investment and Academic Portal. Retrieved on 4 May 2010. www.investopedia.com Read More